Gift Tax on Lifetime Gifts Not Includible in Gross Estate Due to Reimbursement Agreements

(Parker Tax Publishing September 2017)

The Tax Court held that the liability for gift tax on gifts of artwork made within three years of a decedent's death was not includible in the gross estate because the estate would have been entitled to reimbursement from the recipients had it paid the gift taxes. The court also held that the gift recipients could not be apportioned estate tax liability under New Jersey law because they had not received any part of the gross estate and therefore were not transferees to whom estate tax could be apportioned. Sommers v. Comm'r, 149 T.C. No. 8 (2017).

Background

In 2001, Sheldon Sommers asked his attorneys for advice on making a gift of artwork to his three nieces, his closest living relatives, in a way that would reduce or eliminate any gift tax liability. His attorneys devised a plan to transfer the artwork to a newly formed limited liability company (LLC) and then make gifts of ownership units in the LLC to the nieces. The plan involved making the gifts in two stages, with the first transfer of units in 2001 and the rest in 2002 in order to increase the portions of the gifts that could be covered by the annual gift tax exclusion under Code Sec. 2503(b).

Sommers transferred the artwork to the LLC and executed two sets of agreements with his nieces, the first in December 2001 and the second in January 2002. As a result of a March 2002 appraisal, Sommers' lawyers concluded that dividing the transfers of units would not allow for the complete avoidance of gift tax, so the nieces agreed to pay any gift tax on the 2002 transfers. The gift agreements were amended to provide that the nieces agreed to any gift taxes, penalties and interests that might be assessed. The agreements did not specifically refer to the apportionment of estate tax liability resulting from the gifts.

Sommers executed his last will in April 2002, which directed his ex-wife Bernice to pay all debts, including funeral and estate administration expenses, and bequeathed to her all of his estate remaining after payment of the debts. In June 2002, shortly before remarrying Bernice, Sommers filed a lawsuit challenging the validity of the gifts to his nieces and seeking return of the artwork. A similar action was initiated by Bernice in New Jersey, but the validity of the gifts was upheld.

Sommers died in November 2002. The estate tax return for Sommers' estate reported a gross estate of approximately $3.7 million and, after deductions, a taxable estate of $500. The IRS audited the estate's return and increased the value of the taxable estate to approximately $1.1 million. The increase reflected three adjustments. First, the IRS included in the estate the gift tax on the 2002 gifts because they were made less than three years before Sommers' death. Second, the value of the artwork was excluded from the estate. Third, the marital deduction was reduced by approximately $2 million, reflecting the IRS's determination that the estate tax liability resulting from the gift tax inclusion would have to be paid out of marital assets. The parties stipulated that the 2002 gift tax liability was approximately $273,000, which the nieces then paid. The IRS's final Form 1273, Report of Estate Tax Examination Changes, determined an estate tax deficiency of approximately $220,000, which reduced the marital deduction to just over $1 million. The estate challenged the deficiency assessment in Tax Court.

Issues

The first issue before the Tax Court was the deductibility of the gift tax liability. The estate argued that the gift tax was deductible under Reg. Sec. 20.2053-6(d) and that the nieces' payment of the tax did not affect the deductibility because Sommers was deemed to have paid the gift tax under Code Sec. 2502(d). The IRS countered that the gift tax liability was not deductible because the nieces received nothing additional from the estate and thus did not pay the gift tax in their capacity as beneficiaries. It also argued that a deduction for a liability that did not reduce the net amount passing to Sommers' other heirs would subvert the purpose of Code Sec. 2035.

Next, the estate argued that it was entitled as a matter of law to deduct approximately $1.6 million, the value of Sommers' nonprobate property that Mrs. Sommers received that was exempt from the estate's debts under New Jersey law. The general rule is that the marital deduction does not include any property that would have gone to the spouse but is used to satisfy the estate's debts. The estate argued that all of the debts for which the estate claimed deductions on its estate tax return arose under New Jersey law, and accordingly were subject to the limitations and exemptions set forth in the New Jersey statutes. The IRS responded that the marital share of the estate held the only assets available to pay the debts and expenses for which the estate claimed deductions; therefore, those debts and expenses reduced the marital deduction under Reg. Sec. 20.2056-4.

The third issue was whether any estate tax liability could be apportioned to the nieces. New Jersey law generally provides that transferees of any property included in the "gross tax estate" must be apportioned estate tax unless the testator directs otherwise. The gross tax estate means all property required to be included in computing the estate tax. The estate argued that, because the gifts were included as adjusted taxable gifts under Code Sec. 2001(b), they had to be included in computing the estate tax liability. It also argued that the LLC units were net gifts because the nieces agreed to pay the gift tax, so the nieces received a part of the gross tax estate at least equal to the portion enabling them to pay the gift tax. The nieces, as intervenors, argued that the gift tax clawbacks were not transferees' property under the statute. They also argued apportionment would be inconsistent with Sommers' intent as expressed in the gift agreements.

Analysis

The Tax Court held that the gift tax liability was not deductible under Code Sec. 2053(a) because the estate's payment of the liability would have given rise to a claim for reimbursement from the nieces. According to the Tax Court, under longstanding precedent, a claim against an estate is deductible in computing estate tax liability only to the extent it exceeds any right to reimbursement to which its payment would give rise. The estate was not entitled to a deduction for gift tax liability on the 2002 gifts to the nieces because, had the estate paid the taxes, the nieces would have been required under the gift agreements to reimburse the estate.

Next, the Tax Court held that the marital deduction amount depended on the extent to which nonprobate assets were used to pay estate debts and expenses, which was a question of fact. The Tax Court noted that the estate's claim of a $1.6 million marital deduction was inconsistent with its deduction of $413,000 of debts and expenses. The court reasoned that the debts and expenses reported by the estate would be fully deductible only if voluntarily paid before the due date of the estate tax return out of assets that were exempt from claims against the estate under Code Sec. 2053(c)(2). If Mrs. Sommers voluntarily paid debts or expenses of the estate from exempt property, the estate's allowable marital deduction would be reduced. The Tax Court concluded that either the allowable marital deduction was less than the $1.6 million the estate reported, or the estate was not entitled to deduct in full the debts and expenses. It therefore denied the estate's motion for summary judgment on that issue.

The Tax Court also held that no portion of the estate tax could be apportioned to the nieces because they were not transferees of gross tax estate property. Under New Jersey law, if the units the nieces received in 2002 were included in computing the estate tax liability, then they were part of the gross tax estate and the nieces would be transferees to whom estate tax could be apportioned. The Tax Court found that New Jersey courts had not addressed the extent to which their state's apportionment statute provided for the apportionment of estate tax to recipients of lifetime gifts. After reviewing the decisions of other courts in states with similar apportionment statutes, the Tax Court concluded that there were insufficient policy grounds to extend the statute to such recipients. According to the Tax Court, although the amount of gift tax paid on the LLC units was included in the gross estate, the units themselves were not; there was no property included in the gross estate that the nieces received or from which they otherwise benefited. The units were not part of Sommers' gross tax estate under New Jersey law, and the nieces were therefore not transferees to whom estate tax liability could be apportioned, the Tax Court concluded.

The Tax Court also refused to hold as a matter of law that any estate tax due would not reduce Mrs. Sommers' marital deduction. The court determined that New Jersey law requires estate tax to be apportioned so as to preserve, as much as possible, the benefit of a marital deduction. According to the Tax Court, if Mrs. Sommers used property that otherwise would have been exempt from claims against the estate to pay debts and expenses then she may have been a transferee and subject to apportionment.

For a discussion of the inclusion in the gross estate of gift tax on gifts made within three years of death, see Parker Tax ¶225,320. For a discussion of the effect of a donee's assumption of gift tax liability on the gross estate, see Parker Tax ¶222,765. For a discussion of the estate tax marital deduction see Parker Tax ¶227,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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